In a shocking multibillion-dollar collapse, FTX, the third-largest cryptocurrency exchange in the world recently filed for bankruptcy protection, jolting the crypto market.
Founded by Sam Bankman-Fried, FTX evolved into one of the market's most popular cryptocurrency exchanges, becoming the third largest by volume in just three short years. FTX's mission to “develop a platform robust enough for professional trading firms and intuitive enough for first-time users” enticed millions of people, investment firms, and companies into losing billions of dollars overnight due to failed regulatory and compliance frameworks and unethical treasury management operations.
At its peak, the valuation of the company rested at $32 billion earlier this year. But after Binance recently backed out of a deal to acquire FTX, users withdrew around $6 billion in funds in a massive sell-off, causing a 72% drop in FTT’s price, the native crypto token of the FTX trading platform. This triggered all of FTX’s associated assets to drop.
The fall of FTX was not just in this sell-off, but aided by the company’s decision to lend billions of dollars worth of customer assets to sister company, Alameda Research, for trading. As Bankman-Fried's crypto hedge fund and sister company to FTX illegally utilized customers' funds without their knowledge for trading, the company also leveraged FTT as collateral for these trades.
When the token price drastically dropped and became virtually worthless, the collateral became insufficient to cover all trades. The inability of Alameda Research to repay its loans to FTX ultimately led to a major liquidity failure for the company accounting for unimaginable financial losses for associated trading firms, partnerships, and customers.
Amid concern surrounding the improper use of customers’ money, FTX is currently under investigation by the Bahamas Securities Commission, as well as the Department of Justice, and the Securities and Exchange Commission for violations of U.S. securities law.
Our Chief Compliance Officer, Luis Trujillo, weighs in on the pitfalls of regulation surrounding FTX and why a proper regulatory framework is critical for long-term resiliency, reliability, and security in the financial services industry.
Over the past months, we have seen several prominent firms in the cryptocurrency space file for bankruptcy and straight-up fail. They’ve failed the public, they’ve failed their investors, but most importantly, they’ve failed their customers. Three Arrows Capital / Terra (then Celsius), and now FTX — the one that I strongly expect will be the icing on the cake — and the one that I hope makes regulators in the U.S. and across the globe wake up.
In the meantime, other firms in the financial space should analyze and take the proper measures to ensure our firms, clients, and their customers are protected. So let’s begin the analysis.
What Do Each of These Cases Have in Common?
What happened at Celsius and FTX is similar from a concept perspective — they were lending the crypto funds that their customers would deposit and store to third parties that failed to repay the loans. When those third parties failed to pay back their loans, Celsius and FTX didn’t have crypto available to fund their clients' withdrawals. While their operations and specifics were quite different, they both encountered a liquidity shortfall that transpired due to unsafe and unsound practices internally within these firms.
Why Is This Happening?
The reason this is happening is simple. Poor decision-making, or unsafe and unsound practices. That’s the common theme across the board. A lack of an appropriate regulatory framework has fostered unsafe, unsound, and unethical practices at these crypto firms, which in turn gave them the opportunity to unsustainably thrive. What do I mean by this? Even if any of these companies were directly or indirectly regulated to some extent for their crypto offering or other underlying activities, the framework developed to supervise these firms and intermediaries supporting their operations was not sufficient.
In contrast, let’s look at U.S. chartered banks. They are limited on the ratio of funds they can lend off their balance sheet, and if these ratios are breached materially or regularly, the bank’s charter is at risk. On the other hand, no one was supervising what either Celsius or FTX were doing with the liquidity and treasury management of the crypto they were storing for their customers, giving these firms the freedom to uncontrollably lend crypto assets that they were holding for their customers to related and/or unrelated third parties without an appropriate control framework. Lending was done without regard for the consumers and companies that entrusted them with crypto assets. In each case, the business model failed due to a lack of controls and safeguards in place.
How Can This Be Avoided in the Future?
Being properly regulated and maintaining an internal control environment that enforces sound practices across an organization is key. Partnering with firms that hold the same values is equally important. When talking about dealing with the hard-earned money of your customers, these principles should be front and center and non-negotiable. Firms that are fully and independently regulated may have a rigorous due diligence process, but that is because their goal and responsibility is to provide long-term resiliency, reliability, and security. Working with partners that are not regulated or licensed brings risks that no one can afford.
Whether you’re a consumer deciding whether to try a new financial product or service, or whether your company is vetting a new embedded finance provider, do your homework and make sure the provider you are considering is regulated, licensed, and can provide you long term resiliency, reliability, and security. It matters. That's what we do at Alviere.